The Hong Kong Securities and Futures Commission (SFC) has issued a circular on leveraged and inverse products (L&I Products) setting out the requirements under which the regulator would consider authorising exchange-traded funds (ETFs) with such characteristics for public offering in Hong Kong under sections 104 and 105 of the Securities and Futures Ordinance.
Under the new requirements, the regulator will only consider for approval leverage and inverse ETFs featuring offshore indices. In a second stage, the SFC will review after six months to consider the inclusion of onshore (Hong Kong) underlyings.
"As one of the market makers, we are already well prepared for the upcoming launch of leverage and inverse ETFs," said Antoine de Saint Vaulry (pictured), head of ETF and flow trading Asia at Commerzbank. "In the past week we have received enquiries from different issuers in terms of cooperation, it may take three months to see the first leveraged ETFs coming out in the market."
Although the ETF market in Hong Kong is behind other neighbouring markets such as Taiwan and Singapore which have already approved leverage/inverse ETFs, "the regulator in Hong Kong needs to make sure the market is ready and [that] there will be no negative effect with the launch of new products", according to de Saint Vaulry.
The recent stock market volatility in mainland China and Hong Kong has hit investors but also opened up opportunities for more tactical trading, and the approval of leveraged and inverse ETFs is seen in some quarters as a way to provide retail investors with more choices to either increase participation or make bearish positions in the market, as a way to better hedge their investment risk.
Up until now, only physical and synthetic ETFs could be traded in Hong Kong limiting the scope to long-only positions, with structured products being a popular vehicle to get enhanced exposure or invest on bearish strategies, however, de Saint Vaulry doesn't see the approval of leveraged ETFs as a threat to structured products.
"It's always good to have more variety in the market which may help to grow the pie bigger," said de Saint Vaulry. "[Perhaps] products with strong leveraging features such as constant proportion portfolio insurance (CPPI) strategies and warrants will be more affected."
According to the SFC, the highest leveraging factor accepted for leveraged ETFs will be two times and one time for inverse strategies, so that if the underlying recorded a 10% increase in one day, the leveraged ETFs will provide a return of 20% and the inverse ETF will provide a loss of 10%.
"This is just to test water," said de Saint Vaulry adding that the market expects the requirements to be relaxed in future.
The approved leveraged and inverse ETFs will not be named 'ETFs' as SFC considers that the characteristic of these products is different from traditional ETFs. L&I Products will be put under a new, standalone product category in the websites of the SFC and Hong Kong Exchanges and Clearing Limited (HKEX). They will have their own distinctive stock short names, beginning with an "L" for Leveraged Products, and an "I" for Inverse Products. Distinct stock code ranges will also be designated for L&I Products, stated the regulator.
For L&I Products using swap-based synthetic replication structures, the SFC expects "clear disclosure" of the costs of entering into the swap with the counterparty, and providers will also be required to to make available a "performance simulator", enabling investors to select a historical time period and simulate the performance of products during that period based on historical data.
The SFC is also prompting intermediaries to observe all the applicable requirements with respect to derivative products, and ask for "appropriate measures" such as providing training to staff, and ensure that staff is "familiar with the risks and features of these products and comply with the applicable requirements when serving their clients".
"In doing so intermediaries need to be aware that gearing to invest in a product compounds the underlying risk", said the regulator.
Click here to read the full SFC circular.
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